Total AUM in private markets has risen sharply in recent years as investors have clamoured to increase their portfolio exposure to illiquid assets. As McKinsey point out in their Global Private Markets Review 2022, year-on-year AUM rose from $7.4 trillion to $9.8 trillion while fundraising activity totaled an impressive $1.2 trillion.

Whether this pace of growth can continue, however, is open to debate. Some believe fundraising will slow in 2023 as LPs focus more on existing relationships and opt to refrain from making new allocations as the effects of economic uncertainty seep in to private markets.

Jason Strife, a senior managing director at Churchill Asset Management, which invests in mid-market PE funds, was quoted in Pitchbook saying: “As public markets are down, there could be the denominator-effect dynamic impacting certain pockets of capital on the LP side.”

Portfolio construction is going to take on a different hue as investors assess how much private equity fund valuations are impacted.

This year has been unusual in the fact that both equity and bond markets have fallen in tandem. “During the post-World War Two period, there has only been one other year when that was true. This has had more of an impact on investor portfolios than is generally discussed or acknowledged,” comments Paul Buckley, co-founder of FIRST avenue, a global placement agent.

The impact of COVID, coupled with rising geopolitical tensions, strained supply chains, tight labour markets, spiralling European energy costs and decade-high inflation, has shifted the financial world on its axis.

Adapting to these shifting economic sands is going to require effective portfolio and risk management, and strong lines of communication with LPs.

Buckley sees two things happening next year:

“Firstly, economies are going to fall off a cliff in terms of economic growth but inflation is not going to come down. The one wildcard is that the war in Ukraine suddenly stops, but that is unlikely.

“Secondly, investors went into this year overexposed to private equity and venture capital and generally underexposed to asset classes that might protect them from inflation i.e. private credit and infrastructure.

“My thesis for 2023 would be that capital will continue to go to the biggest fiduciaries at an accelerated pace, and there will be a divergence between how easy it is to raise capital in different asset classes. It will be very hard for VC, hard for PE, tough for private credit, and moderately tough for infrastructure. The market will discern, more than ever, between the best and worst fiduciaries.”

Valuation reality check

The scale of retrenchment in the venture capital market has been notable in 2022. Companies that had previously enjoyed successively larger series fundraising rounds suddenly found their valuations drastically fall, causing investors to take a significant mark-to-market hit in their portfolios. “I think the market pullback is here,” Ryan Bloomer, founder and managing partner at K50 Ventures, told Crunchbase. “I think what we saw happen in the public market is leading the private to a big dose of reality.”

While the economic benefits of co-investing are well known, getting comfortable with company valuations in a recessionary climate will test the nerves of LPs and require sufficient data in order to identify risks and stresses on corporate balance sheets.

The same is true – if not more so – for LPs who have favoured direct investing and who now find themselves potentially having to work through operational challenges with companies as the economy stutters, without the support of fund sponsors (and their wider operating partner networks).

Lex van Dam, head of deal sourcing for family office Rinkelberg Capital notes that while sourcing direct investments is not that hard, given that valuations have come down and there is less competition, “managing is much harder”.

“If you don’t know the cost of energy, if the supply chain has been interrupted, the consumer hit, wages are rising massively and interest rates have massively increased as well then it is very hard to manage any business,” he says.

Family offices who lack internal investment resources are favouring independent sponsors, beyond traditional GP fund commitments, to access direct investments. This is likely to continue as the next distressed debt cycle develops, presenting attractive buying opportunities in sectors such as real estate.

Equally, some investors view the environment with relish.

“Now, for the first time in a while, we think there will be increasing opportunities in real estate to make purchases,” comments Charlotte Thorne, founding partner of Capital Generation Partners, an investment advisor to family offices. “We are looking at a commercial building in London, which has enough complications in it to make it a niche opportunity and yet sufficient upside to make it appealing for investors who still have dry powder in this area. We are marshalling the troops for a very interesting set of buying opportunities in 2023.”

In many respects, next year, like 2022, is expected to be a stress test for private market portfolios. Those GPs who have lived through previous down cycles will be better prepared but what about the new generation who are still running their first or second fund and have only known a benign market? How they approach portfolio management to overcome this latest crisis will be a key test.

For now, PE managers are not feeling the pinch yet “because numbers have not yet moved significantly”, one investor remarks. Nevertheless, many are focusing on operational improvement and value-add work, as a way to navigate this crisis. Will that mean that larger platforms will be better placed than smaller players? Potentially.

Secondary market liquidity outlook

Liquidity will take on greater significance within private markets as investors weigh up the risks and opportunities in a higher interest rate environment. The private capital secondary market remains the key mechanism for facilitating these changes at speed.

The key question for investors will be: Is this the right portfolio to meet our objectives in an uncertain macro environment?

While the liquidity roadmap is well developed for private equity, one trend to look out for in 2023 will be how much growth is seen in other secondary markets including private credit. Certain defined parts of the private credit market have been dislocated, particularly specialty finance strategies, and currently offer great value.

“We expect secondary deal flow to expand significantly across all types of alternative assets, not just PE buyouts but private credit, infrastructure and real estate,” comments Gerald Carton, Partner, Investor Relations, Coller Capital, a prominent PE secondaries firm.

Coller Capital is forecasting between $130 and $140 billion of secondary transactions for 2022. Since 2012, investors have enjoyed positive cash flows in their PE portfolios, with distributions exceeding capital calls. Over the last six to nine months, this trend has reversed.

“The cost of liquidity has increased substantially since February. It is harder for GPs to exit companies. This is impacting distributions and one of the reasons why investors are using the secondary market as a source of liquidity to generate a DPI,” says Carton.

What price will investors be willing to pay for liquidity if markets remain subdued and valuations soften? Through the first half of last year, the average buyout fund was trading at a 3% price discount. This year, that figure has fallen to 12%, on average.

Democracy for alternatives

Looking ahead, the retail sector could be the next frontier for private markets.

Tapping in to a broader investor base is being helped by the creation of new structures such as the Long-Term Asset Fund (LTAF) in the UK, an open-ended structure designed to give pension investors an easier way to access illiquid assets.

Likewise, in Europe, newly updated ELTIF regulations are set to give retail investors easier access to private equity and other alternative funds. Jurisdictions such as Luxembourg will doubtless see big opportunities over the next few years, if ELTIF adoption starts to take off.

Blockchain technology will be an integral part of the democratisation trend. Partners Group sees it eliminating much of the friction that exists in private equity investing and believes fund tokenisation will be the “new frontier” and further democratise private markets.

In a May keynote interview, Partners Group’s US head of private wealth, Rob Collins, stated: “It is hard to say when this will take place, perhaps in five or even 10 years. However, the retail and DC markets of the future will look fundamentally different to today…”

Firms like Hamilton Lane have moved quickly to tokenise funds to tap in to a wider investor base, while others have sought out to strengthen their talent pool to best position themselves; for example, Apollo Global has hired Christine Moy from JP Morgan to head up its digital asset strategy. Moreover, Apollo raised an average of $1 billion annually from individual investors between 2018 and 2020 and hopes to increase that figure to $15 billion, annually, through 2026.

How prominent any of the above themes become in 2023 will be interesting to observe, as conviction within the market is tested.